SUMMARY: Under section 805(a)(1)(A) of the Dodd-Frank Wall Street Reform and Consumer

Transcription

1 FEDERAL RESERVE SYSTEM 12 CFR Part 234 Regulation HH; Docket No. R-1477 RIN No. AD-7100 AE-09 Financial Market Utilities AGENCY: Board of Governors of the Federal Reserve System ACTION: Notice of Proposed Rulemaking SUMMARY: Under section 805(a)(1)(A) of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank Act or Act ), the Board of Governors of the Federal Reserve System (Board) is required to prescribe risk-management standards governing the operations related to the payment, clearing, and settlement activities of certain financial market utilities that are designated as systemically important (designated FMUs) by the Financial Stability Oversight Council (Council). The Board is proposing to amend the risk-management standards currently in the Board s Regulation HH, Part 234 of Title 12 of the Code of Federal Regulations, by replacing the current risk-management standards in (for payment systems) and (for central securities depositories and central counterparties) with a common set of riskmanagement standards applicable to all types of designated FMUs in proposed These new risk-management standards are based on the Principles for Financial Market Infrastructures (PFMI), which were developed by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) and published in April DATES: Comments on this notice of proposed rulemaking must be received by March 31, 2014.

2 ADDRESSES: You may submit comments, identified by Docket No. R-1477 and RIN No AE-09, by any of the following methods: Agency Web site: Follow the instructions for submitting comments at Federal erulemaking Portal: Follow the instructions for submitting comments. Include the docket number in the subject line of message. Facsimile: (202) or (202) Mail: Robert dev. Frierson, Secretary, Board of Governors of the Federal Reserve System, 20 th Street and Constitution Avenue NW, Washington, DC All public comments are available from the Board s Web site at as submitted, unless modified for technical reasons. Accordingly, your comments will not be edited to remove any identifying or contact information. Public comments may also be viewed electronically or in paper form in Room MP-500 of the Board s Martin Building (20 th and C Streets NW) between 9 a.m. and 5 p.m. on weekdays. FOR FURTHER INFORMATION CONTACT: Jennifer A. Lucier, Deputy Associate Director (202) , Kathy C. Wang, Senior Financial Services Analyst (202) , or Emily A. Caron, Senior Financial Services Analyst (202) , Division of Reserve Bank Operations and Payment Systems; Christopher W. Clubb, Special Counsel (202) or Kara L. Handzlik, Counsel (202) , Legal Division; for users of Telecommunications Device for the Deaf (TDD) only, contact (202)

3 SUPPLEMENTARY INFORMATION: I. Background A. Title VIII of the Dodd-Frank Act Title VIII of the Dodd-Frank Act, titled the Payment, Clearing, and Settlement Supervision Act of 2010, was enacted to mitigate systemic risk in the financial system and to promote financial stability, in part, through an enhanced supervisory framework for designated FMUs. 1 Section 803(6) of the Act defines an FMU as a person that manages or operates a multilateral system for the purposes of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person. Pursuant to section 804 of the Act, the Council is required to designate those FMUs that the Council determines are, or are likely to become, systemically important. 2 Such a designation by the Council makes an FMU subject to the supervisory framework set out in Title VIII of the Act. The supervisory framework established under Title VIII includes risk-management standards for designated FMUs that take into consideration relevant international standards and existing prudential requirements. Section 805(a)(1)(A) of the Act requires the Board to prescribe risk-management standards governing the operations related to the payment, clearing, and settlement activities of certain designated FMUs. 3 In addition, section 805(a)(2) of the Act 1 The Dodd-Frank Act, Pub. L. No , 124 Stat. 1376, was signed into law on July 21, For these purposes, section 803(9) of the Dodd-Frank Act defines systemically important and systemic importance as a situation in which the failure of or disruption to the functioning of an FMU could create, or increase, the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the financial system of the United States. 12 U.S.C. 5462(9). 3 Currently, two of the eight FMUs that have been designated by the Council are subject to the risk-management standards promulgated by the Board under section 805(a)(1)(A) The Clearing House Payments Company, L.L.C., on the basis of its role as operator of the Clearing House Interbank Payments System, and CLS Bank International. 3

4 grants the U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC) the authority to prescribe regulations containing risk-management standards for a designated FMU that is, respectively, a derivatives clearing organization (DCO) registered under section 5b of the Commodity Exchange Act or a clearing agency registered under section 17A of the Securities Exchange Act of As set out in section 805(b) of the Act, the applicable risk-management standards must (1) promote robust risk management, (2) promote safety and soundness, (3) reduce systemic risks, and (4) support the stability of the broader financial system. Further, under section 805(c), the risk-management standards may address areas such as (1) risk-management policies and procedures, (2) margin and collateral requirements, (3) participant or counterparty default policies, (4) the ability to complete timely clearing and settlement of financial transactions, (5) capital and financial resource requirements for designated FMUs, and (6) other areas that are necessary to achieve the objectives and principles for risk-management standards in section 805(b). Designated FMUs are required to conduct their operations in compliance with the applicable risk-management standards. Compliance is examined by the federal agency that has primary jurisdiction over a designated FMU under federal banking, securities, or commodity futures laws (the Supervisory Agency ). 4 B. Risk-Management Standards for Designated Financial Market Utilities On July 30, 2012, the Board adopted Regulation HH to implement, among other things, the statutory provisions under section 805(a)(1)(A) of the Dodd-Frank Act. 5 Regulation HH established two sets of risk-management standards for certain designated FMUs: one set of risk- 4 The Act s definition of Supervisory Agency is codified at 12 U.S.C. 5462(8) C.F.R. Part

5 management standards for designated FMUs that operate a payment system ( 234.3(a)) and another set for designated FMUs that operate a central securities depository or a central counterparty ( 234.4(a)). 6 The Regulation HH standards do not apply to designated FMUs for which the CFTC or the SEC is the Supervisory Agency. 7 In adopting Regulation HH, the Board considered relevant international standards as well as the Board s Federal Reserve Policy on Payment System Risk (PSR policy). 8 As noted in the preamble to the final rule for Regulation HH, the CPSS and IOSCO finalized the PFMI in April The Board also noted in the preamble that it anticipated reviewing the PFMI, consulting with other appropriate agencies and the Council, and seeking public comment on the adoption of revised standards for designated FMUs based on the PFMI. The PFMI updated, harmonized, strengthened, and replaced the previous international risk-management standards for payment systems that are systemically important, central securities depositories, securities settlement systems, and central counterparties. 9 The PFMI addresses areas such as legal risk, governance, credit and liquidity risks, operational risk, and 6 At the time of the rulemaking, the Board acknowledged that most designated FMUs that operate as central securities depositories or central counterparties would be subject to the risk-management standards promulgated by the CFTC or SEC. The Board, however, adopted standards for designated FMUs that operate as central securities depositories, central counterparties, or both, to address the event that a designated FMU operates as one of the two types of FMUs and is not required to register as derivatives clearing organization or a clearing agency with the CFTC or SEC, respectively C.F.R The relevant international standards were the 2001 Committee on Payment and Settlement Systems (CPSS) report on the Core Principles for Systemically Important Payment Systems, the 2001 CPSS and the Technical Committee of the International Organization of Securities Commissions (IOSCO) report on the Recommendations for Securities Settlement Systems, and the 2004 CPSS-IOSCO report on the Recommendations for Central Counterparties. The Board previously incorporated these international standards into its PSR policy. 9 The PFMI also establishes minimum requirements for trade repositories, which have emerged internationally as an important category of financial market infrastructure. The term financial market utility as defined in Title VIII of the Dodd-Frank Act excludes trade repositories. 5

6 general business risk. 10 It sets forth 24 principles, each with (1) a headline standard that frames the overall risk-management objective of the principle, (2) a list of key considerations that elaborate on the headline standard, and (3) accompanying explanatory notes that discuss the objective and rationale of the principle and provide additional guidance on how the principle may be implemented. The Board believes that the risk-management standards in Regulation HH should be revised in consideration of the PFMI. The PFMI establishes an important framework for promoting sound risk management in payment, clearing, and settlement systems and financial stability more broadly. The report reflects more than a decade of experience with international risk-management standards for these types of systems, important lessons learned from the financial crisis, and other relevant policy work by the international standard-setting bodies. As described in more detail below, risk-management standards based on the PFMI may improve upon the standards currently in Regulation HH and will further promote the objectives of the risk-management standards for designated FMUs set out in section 805(b) of the Dodd-Frank Act. In addition, the PFMI is widely recognized as the most relevant set of international riskmanagement standards for payment, clearing, and settlement systems. The Financial Stability Board (FSB), which includes U.S. authorities, has endorsed the PFMI and has replaced the previous sets of risk-management standards with the PFMI in its Key Standards for Sound Financial Systems. 11 In addition, the Basel Committee on Banking Supervision considers the 10 The PFMI reflects broad market input from FMUs, their participants, authorities, and others. A consultative version of the PFMI was published in March CPSS and IOSCO received 120 comment letters on the consultative version. All designated FMUs, as well as many of their major participants, provided comments on the consultative report. 11 The FSB is an international forum that was established to develop and promote the implementation of effective regulatory, supervisory, and other financial sector policies. The FSB includes the U.S. Department of the Treasury, 6

7 application of the PFMI as an important factor in determining capital charges for bank exposures to central counterparties related to over-the-counter derivatives, exchange-trade derivatives, and securities financing transactions. 12 The Board believes that the implementation of risk-management standards based on the PFMI by the relevant payment, clearing, and settlement systems and their regulators, both domestically and internationally, can help promote the safety and efficiency of these systems and financial stability more broadly. Implementation also supports the initiatives of the Group of Twenty Finance Ministers and Central Bank Governors (G20) and the FSB to strengthen core financial infrastructures and markets around the world. 13 Widespread implementation also reduces potential conflicts among domestic and foreign authorities regarding prudential requirements for FMUs, and provides a more consistent framework among relevant domestic and foreign authorities for assessing the risks and risk management of FMUs with cross-market, cross-border, or cross-currency operations. Since April 2012, many central banks and market regulators have taken steps to incorporate the PFMI into their respective legal and regulatory frameworks that apply to systemically important financial market infrastructures. 14 the Board, and the SEC. For the FSB s Key Standards for Sound Financial Systems, see 12 See Basel Committee on Banking Supervision (BCBS), interim rules on Capital Requirements for Bank Exposures to Central Counterparties, July 2012, and BCBS, Capital Treatment of Bank Exposures to Central Counterparties, consultative document, June See, G20 Declaration on Strengthening the Financial System (April 2009), center/international/g7-g20/documents/london%20april%202009%20fin_deps_fin_reg_annex_020409_- _1615_final.pdf. 14 For an overview of how the PFMI is being implemented by different authorities around the world, see CPSS- IOSCO, Implementation Monitoring of PFMIs Level 1 Assessment Report, August

8 II. Explanation of Proposed Rules The Board proposes to amend Regulation HH by replacing the existing risk-management standards with a set of standards based on the PFMI and making conforming changes to the definitions. In developing the proposal, the Board has considered the PFMI as the relevant international standards applicable to payment, clearing, and settlement systems. In implementing the proposed revisions to Regulation HH, the Board anticipates using the PFMI as a reference as it establishes its supervisory planning and analysis tools for each designated FMU for which it is the Supervisory Agency. The Board requests comment on all aspects of the proposed rules. In addition, the Board requests comment on specific questions set out with respect to certain of the risk-management standards as discussed below. Where possible, commenters should provide both quantitative data and detailed analysis in their comments, particularly with respect to suggested alternatives to the proposed standards. Commenters should also explain the rationale for their suggestions. A. Proposed Definitions The Board proposes to amend Regulation HH by revising three definitions, adding six definitions, and deleting one definition. These proposed amendments constitute conforming changes or provide clarity with respect to the proposed revisions to the riskmanagement standards. Central counterparty. The Board proposes to revise the definition of central counterparty to describe more accurately the nature of the relationship between the central counterparty and the original counterparties with respect to a particular trade. The existing definition, an entity that interposes itself between the counterparties to trades, acting as the buyer to every seller and the seller to every buyer, is being revised to read, an entity that 8

9 interposes itself between the counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer. Designated financial market utility. The Board proposes to revise the definition of designated financial market utility for clarity regarding designation rescission. The existing definition, a financial market utility that the [Council] has designated under section 804 of the Dodd-Frank Act is being revised to read, a financial market utility that is currently designated by the [Council] under section 804 of the Dodd-Frank Act. Under section 804(b) of the Act, a designated FMU may have its designation rescinded if the Council determines the designated FMU no longer meets the standards for systemic importance. The proposed revision is intended to clarify that Regulation HH applies only to FMUs with designations that are currently effective. If the Council rescinds a designation of an FMU, the FMU is no longer subject to the provisions of Title VIII of the Act or any rules or orders prescribed under Title VIII, including the risk-management standards set out in Regulation HH. Central securities depository. The Board proposes to revise the definition of central securities depository. The existing definition, an entity that holds securities in custody to enable securities transactions to be processed by means of book entries or an entity that enables securities to be transferred and settled by book entry either free of or against payment, is being revised to read, an entity that provides securities accounts and central safekeeping services. This revision reflects a narrower set of functions that a central securities depository can provide and better distinguishes this type of FMU from a securities settlement system, which will be covered by a new term as described below. Securities settlement system. The Board proposes to add the term securities settlement system, which means an entity that enables securities to be transferred by book entry and 9

10 allows transfers of securities free of or against payment. The term securities settlement system was previously embedded in the Regulation HH definition for central securities depository because a central securities depository typically also performs the securities settlement function. The Board proposes this separation of the two functions central securities depositories and securities settlement systems in order to accommodate any systems in which the central securities depository does not also operate a securities settlement system. Nonetheless, the Board recognizes that one entity can perform both functions and satisfy both definitions. Backtest and stress test. The Board proposes to add the terms backtest as used in proposed 234.3(a)(6)(Margin) and stress test as used in proposed 234.3(a)(4) (Credit risk) and proposed 234.3(a)(7) (Liquidity risk). Under the proposal, backtest is defined as the ex post comparison of realized outcomes with margin model forecasts to analyze and monitor model performance and overall margin coverage. Stress test is defined as the estimation of credit or liquidity exposures that would result from the realization of potential stress scenarios, such as extreme price changes, multiple defaults, and changes in other valuation inputs and assumptions. These proposed definitions provide further clarity to designated FMUs with regard to compliance with the above standards. Recovery and wind-down. The Board proposes to add the terms recovery and winddown, used in proposed 234.3(a)(3) (Framework for the comprehensive management of risks) and 234.3(a)(15) (General business risk). Under the proposal, recovery is defined as the actions of a designated financial market utility consistent with its rules, procedures, and other ex ante contractual arrangements, to address any uncovered credit loss, liquidity shortfall, capital inadequacy, or business, operational or other structural weakness, including the replenishment of 10

11 any depleted prefunded financial resources and liquidity arrangements, as necessary to maintain the designated financial market utility s viability as a going concern. The proposed definition of recovery is for purposes of proposed 234.3(a)(3) and 234.3(a)(15) only and not in the context of business continuity management under proposed 234.3(a)(17). The Board proposes to define wind-down as the actions of a designated financial market utility to effect the permanent cessation, sale, or transfer of one or more of its critical operations or services. Links. The Board proposes to add the term link as used in proposed 234.3(a)(20) (Links to other financial market utilities). For the purposes of 234.3(a)(20), link is defined as a set of contractual and operational arrangements between two or more central counterparties, central securities depositories, or securities settlement systems that connect them directly or indirectly, such as for the purposes of participating in settlement, cross margining, or expanding their services to additional instruments and participants. Payment system. The Board proposes to remove the definition of payment system from Regulation HH because the term is neither used in the proposed rule nor used in any other section of Regulation HH. The term payment system is currently included in Regulation HH because there is list of risk-management standards for payment systems in that is separate from the list of standards for central securities depositories and central counterparties in Under the proposed rule, there would be only one list of standards for all types of designated FMUs, so the separate term is no longer necessary. The Board specifically requests comment on whether the proposed definitions are clear and sufficiently detailed and whether additional definitions are needed to implement the proposed rules. 11

12 B. Proposed Standards for Designated Financial Market Utilities As noted above, the Board proposes to replace the two current sets of standards under 234.3(a) and 234.4(a) with one set of standards for all types of designated FMUs under revised 234.3(a). In certain cases where proposed standards would only apply to a particular type of designated FMU, the type of designated FMU is specified in the proposed standard. The Board believes the proposed revisions, which reflect the new international standards in the PFMI, improve the current risk-management standards under Regulation HH and further the objectives in section 805(b) of the Dodd-Frank Act. Additionally, in considering the PFMI, the proposed revisions reflect the most recent and relevant views on comprehensive risk management by FMUs. Furthermore, adopting a common set of standards across all types of designated FMUs will help remove any confusion that can be caused by perceived inconsistencies in the wording in two similar sets of requirements set out in the same regulation. The Board, however, recognizes that certain proposed revisions represent new or heightened requirements relative to the baseline requirements established under the current set of risk-management standards. The Board also understands the need to weigh the risk-reduction benefits of and any burden that may be imposed by a particular rulemaking. Among other things, the Board has compared the proposed standards with the baseline standards under current Regulation HH to identify and analyze potential incremental burden, and is considering establishing different effective dates for certain proposed standards that may require additional time for a designated FMU to implement. Comparison to baseline requirements under current Regulation HH. Consistent with current Regulation HH and the Board s longstanding approach in its supervision and oversight of FMUs, the proposed standards generally employ a flexible, principles-based approach to permit a 12

13 designated FMU to employ a cost-effective method for compliance, so long as the method chosen achieves the risk-mitigation goals of the standard. In addition, the standards are intended to permit the risk-management goals to be pursued in light of evolving market conditions, technology, and risk-management techniques and systems. In several cases, however, the Board proposes explicit minimum requirements, including minimum frequencies for testing requirements and methods of calculating a minimum level of financial resources, which are drawn from PFMI key considerations and explanatory notes. The Board selected explicit minimum requirements that the Board believes a designated FMU must be able to meet in order to achieve the overall objective of a particular standard. Although some of these additions constitute new or heightened requirements relative to the current requirements in Regulation HH, many of the additions represent the Board s existing supervisory practice with respect to designated FMUs for which the Board is the Supervisory Agency. In comparing the proposed revised risk-management standards to the current standards in Regulation HH, the Board has identified three broad types of revisions: (1) those that essentially carry over a current standard under Regulation HH; (2) those that establish a standard that is new to Regulation HH, but represent an expectation that is a prudential objective of the Board s current supervisory process or a specific Board-imposed requirement for a particular designated FMU; and (3) those that establish a standard that is new or heightened to both Regulation HH as well as either the current supervisory process or a specific Board-imposed requirement for a particular designated FMU. 15 The Board recognizes that the incremental burden associated with each type of proposed revision may vary by designated FMU. 15 The Board may have additional statutory authority over a particular designated FMU that is subject to Regulation HH, which would allow the Board to apply other requirements or conditions on the FMU in those contexts. For example, the Board may set conditions on an FMU s membership in the Federal Reserve System under the Federal Reserve Act. 13

14 A majority of the proposed revisions to 234.3(a) are similar in content and application to existing Regulation HH standards. In these cases, differences between the current standard and the proposed standard generally result from conforming edits to harmonize the originally separate standards into one set of standards. These proposed standards include proposed 234.3(a)(1) on legal basis, proposed 234.3(a)(4)(i) on credit risk, proposed 234.3(a)(8) on settlement finality, proposed 234.3(a)(9) on money settlements, and proposed 234.3(a)(18) on access and participation requirements. The Board does not anticipate that minor differences in wording of the rule text will impose any significant incremental burden on designated FMUs that are already in compliance with Regulation HH. With respect to some other proposed revisions to 234.3(a), although they establish a standard or parts thereof that is new to Regulation HH, the designated FMU may already meet the standard through the Board s current supervisory process or as a part of a specific Boardimposed requirement. These proposed revisions include paragraphs (a)(3)(i) and (ii) on the comprehensive management of risks, (a)(4)(ii) on credit risk, and (a)(7)(i)-(v) on liquidity risk. There may be minimal costs associated with demonstrating compliance with the proposed revision and incorporating it into any formal compliance documentation. The Board, however, does not anticipate this type of revision to impose significant burden. Other proposed revisions to 234.3(a) establish a standard or parts thereof that is new or heightened to both Regulation HH and the current supervisory process. These proposed revisions, depending on the designated FMU, may include proposed 234.3(a)(3)(iii) on plans for recovery or orderly wind-down, proposed 234.3(a)(15)(i) and (ii) on maintaining sufficient liquid net assets funded by equity and a viable capital plan, and proposed 234.3(a)(19) on tiered participation arrangements, which the Board recognizes may impose costs on designated 14

15 FMUs to implement. The costs can be viewed as a designated FMU s incremental expenses in establishing and maintaining the systems and procedures necessary to meet the standards over and above the risk-management measures it has currently in place to comply with the current Regulation HH standards or would have otherwise adopted for business reasons. If these costs are passed on to a designated FMU s participants, they can take the form of higher transaction costs and margin or collateral costs. These costs should be weighed against the societal benefit of stability in the financial system and the economy more broadly. These new standards are meant to help achieve the financial stability and systemic riskreduction objectives of Title VIII of the Act. As such, the key benefits of these proposed standards are in minimizing the probability of recurrent financial crises and avoiding events in which firm-level distress leads to a market-wide disruption or even an economic recession. Such benefits are difficult to quantify, because it would require the computation of the probability of a crisis with and without regulatory change. Such computations generally cannot produce credible figures. To the extent possible, the Board provides instead its qualitative reasons for proposing requirements that may impose an incremental cost, including its explanation of the importance of these requirements to risk management and systemic-risk reduction. The Board provides this explanation in the discussion for each standard below. Effective and compliance dates. The Board recognizes that certain new or heightened requirements may require more time for designated FMUs to implement and achieve compliance. Any delay in implementation, however, must be balanced against the risks presented to the financial system during the period that a designated FMU is not required to comply with an applicable risk-management standard. As discussed below, the Board therefore 15

16 is considering different compliance dates to provide sufficient lead time for certain new or heightened requirements. The Board is proposing that the requirements proposed in 234.3(a) become effective and require compliance 30 days from the date the final rule is published in the Federal Register, with the exception of establishing plans for recovery or orderly wind-down, set forth in proposed 234.3(a)(3)(iii); addressing uncovered credit losses, set forth in proposed 234.3(a)(4)(vi); addressing liquidity shortfalls, set forth in proposed 234.3(a)(7)(viii); maintaining sufficient liquid net assets funded by equity and a viable capital plan, set forth in proposed 234.3(a)(15)(i) and (ii); managing risks arising in tiered participation arrangements, set forth in proposed 234.3(a)(19); and providing comprehensive public disclosure, set forth in proposed 234.3(a)(23)(iv). The Board is proposing that compliance with these proposed requirements be required six months from publication of the final rule. The Board believes the revised risk-management standards as proposed, including any that may impose incremental burden to designated FMUs, achieve an appropriate balance between reducing systemic risk through enhanced risk management of designated FMUs and minimizing incremental burden associated with implementing any new or heightened requirements. With respect to the set of the risk-management standards set out in the proposed rule, the Board is specifically requesting comment on the following questions: Q.0.1. Are the proposed standards reasonable risk-mitigation tools? Q.0.2. Is six months from publication of the final rules for designated FMUs to comply with the proposed requirements identified above (that is, proposed 234.3(a)(3)(iii), (a)(4)(vi), (a)(7)(viii), (a)(15)(i)-(ii), (a)(19), and (a)(23)(iv))? 16

17 Should the Board propose alternative compliance dates for these or any other proposed requirements? Q.0.3. What are the costs that are imposed by the proposed standards? Are there ways to meet the proposed standards other than those identified as examples in the discussion on each standard below? Q.0.4. What are other benefits that are achieved by the proposed standards? 1. Legal Basis Proposed 234.3(a)(1) requires the designated FMU to have a well-founded, clear, transparent, and enforceable legal basis for each material aspect of its activities in all relevant jurisdictions. 16 A designated FMU s legal basis consists of its rules, procedures, and contracts as well as the legal framework (that is, applicable laws and regulations) under which it operates. The legal basis defines, or provides the foundation for relevant parties to define, the rights and obligations of the designated FMU, its participants, and other relevant stakeholders (such as customers of participants, custodian banks, settlement banks, and service providers). Most riskmanagement tools rely on assumptions regarding the manner and time at which these rights and obligations arise through the designated FMU s operations. Sound and effective risk management, therefore, is dependent on the enforceability of these rights and obligations. If the legal basis for a designated FMU s activities and operations is inadequate or uncertain, the designated FMU, its participants, and their customers may face unexpected or unmanageable credit or liquidity risks, which may also create or amplify systemic risks. 16 For similar corresponding standards under current Regulation HH, see 234.3(a)(1) for payment systems and 234.4(a)(1) for central securities depositories and central counterparties. 17

18 While the Board acknowledges that an FMU cannot control or dictate its governing laws or regulations, a designated FMU must take steps to manage its legal risk within this environment, such as by conducting legal due diligence to ensure that its rules, procedures, and contractual provisions are consistent with and enforceable under the legal framework in each applicable jurisdiction. In particular, these rules, procedures, and contracts should be clear regarding material aspects of the designated FMU s activities, such as settlement finality, netting arrangements, and default procedures. If a designated FMU operates across multiple jurisdictions, it must confirm the legal basis for all material aspects of its activities in all relevant jurisdictions to mitigate legal risks. A designated FMU must be able to articulate, in a clear and understandable manner, its compliance with applicable laws and regulations and the enforceability of its rules, procedures, or contracts under those law and regulations. When appropriate, a designated FMU may need to obtain well-reasoned and independent legal opinions or analyses on the material aspects of its activities. Further, when evaluating the enforceability of its rules and procedures, a designated FMU may need to consider different scenarios, such as implementation of its plans for recovery or orderly wind-down, the insolvency or resolution of a participant, and the potential for conflictof-laws issues, and must take steps to mitigate any identified legal risks. 2. Governance Proposed 234.3(a)(2) sets out the requirements that apply to a designated FMU s governance arrangements. 17 Governance is the set of relationships among the designated FMU s stakeholders, including its owners, board of directors (or an equivalent body), management, 17 For similar corresponding standards under current Regulation HH, see 234.3(a)(10) for payment systems and 234.4(a)(8) for central securities depositories and central counterparties. 18

19 participants, and other relevant parties (such as customers of participants, other interdependent FMUs, and the broader market). Governance arrangements define the structure under which the designated FMU s board of directors and management operate. Sound governance is essential to achieving comprehensive and effective risk management at a designated FMU. The way in which a designated FMU s governance arrangements are structured, including the definition of its lines of authority, responsibility, and accountability, affects the fundamental decisionmaking within the designated FMU, including decisionmaking involving risk management. Furthermore, governance arrangements that promote sound risk-management decisions and practices, in turn, help provide a basis for compliance with the other risk-management standards in Regulation HH. For these reasons, effective, accountable, and transparent governance arrangements are critical to the effective risk management of a designated FMU. Under proposed 234.3(a)(2)(i), a designated FMU must establish and document clear and transparent governance arrangements. Clarity and transparency in a designated FMU s governance arrangements promote accountability by providing relevant stakeholders with the information necessary to understand how decisions are made and what the chosen course of action is intended to accomplish. Key components of an FMU s governance arrangements that must be clear and transparent include the (a) role and composition of the board and any board committees, (b) senior management structure, (c) reporting lines between management and the board, (d) ownership structure, (e) internal governance policy, (f) design of risk-management and internal controls, (g) procedures for the appointment of board members and senior management, and (h) processes for ensuring performance accountability. 19

20 Under proposed 234.3(a)(2)(ii) and (iii), a designated FMU must develop governance arrangements that promote the safety and efficiency of its operations and support the stability of the broader financial system and other relevant public interest considerations. The stability of the financial system is an important public interest consideration for all designated FMUs. Certain designated FMUs may have other relevant public interest considerations, such as fostering fair and efficient markets, market transparency, and investor protection. The Board can provide guidance as needed, through ongoing dialogue during the supervisory process, to assist a designated FMU in identifying other public interests that are relevant to its operations. Further, proposed 234.3(a)(2)(iii) requires a designated FMU to develop governance arrangements that support the legitimate interests of relevant stakeholders. These stakeholders include the owners of the FMU, participants of the FMU, and participants customers. Although the mechanisms for involving stakeholders may depend on the type of stakeholder and the particular designated FMU, in general, the involvement of relevant stakeholders in the designated FMU s governance processes, particularly in the determination of the FMU s risk tolerance, the formal objective-setting process, the design of its risk-management framework, and the strategic decisionmaking process may enhance the effectiveness of the FMU s overall risk management. In addition, proposed 234.3(a)(2)(iv)(A) and (B) require the designated FMU to define the structure under which its board and management operate by setting out their responsibilities and defining how they will interact. Proposed 234.3(a)(2)(iv)(A) requires a designated FMU to ensure that its governance arrangements provide clear and direct lines of responsibility and accountability, and proposed 234.3(a)(2)(iv)(B) requires that the board of directors and senior management have roles and responsibilities that are clearly specified. These 20

21 elements must be clear, because the board of directors and senior management are ultimately responsible for managing a designated FMU s business and operations. Proposed 234.3(a)(2)(iv)(C) and (D) address the composition of the board of directors. Proposed 234.3(a)(2)(iv)(C) requires that the designated FMU s governance arrangements be designed to ensure its board consists of suitable individuals with appropriate skills to fulfill its multiple roles identified under proposed 234.3(a)(2)(iv)(B). For example, such arrangements may include a process to identify and regularly review the desired set of skills and experience for the board as a whole and for individual board members. Such arrangements may also include processes and procedures for recruiting board members. Proposed 234.3(a)(2)(iv)(D) requires that the board include a majority of individuals who are not executives, officers, or employees of the designated FMU or an affiliate of the designated FMU; such individuals may offer different 18, 19 perspectives and can help strengthen the board s decisionmaking process. Proposed 234.3(a)(2)(iv)(E) requires the board to establish policies and procedures to identify, address, and manage board member conflicts of interest and to review the performance of the board as a whole and of the individual members on a regular basis. Proposed 234.3(a)(2)(iv)(F) requires the board to establish a clear, documented risk-management framework that includes the designated FMU s risk-tolerance policy, assigns responsibilities and accountability for risk decisions, and addresses decisionmaking in crises and emergencies. 18 For these purposes, affiliate means a company that controls, or is controlled by, or is under common control with the designated FMU. Control of a company means (a) ownership, control, or holding with power to vote 20 percent or more of a class of voting securities of the company; or (b) consolidation of the company for financial report purposes. 19 The Board recognizes that the language on the composition of the board of directors under Principle 2 of the PFMI is phrased differently. Principle 2 states that the board of directors typically requires the inclusion of nonexecutive board member(s). The Board believes the intended effect of having non-executive board members (that is, the ability to make objective decisions), is better achieved when they represent the majority on the board of directors. 21

22 Under proposed 234.3(a)(2)(iv)(G), governance arrangements must be designed to ensure that the designated FMU s senior management has the appropriate experience, skills, and integrity necessary to discharge operational and risk-management responsibilities. For example, the arrangements may include a process to identify and regularly review the desired set of skills and experience for the individual senior management positions. With respect to ensuring the integrity of senior management, a designated FMU may establish rules of conduct, provide ethics guides and training, and conduct background checks. Proposed 234.3(a)(2)(iv)(H) and (I) address the important role that the riskmanagement and internal audit functions serve in a designated FMU. A designated FMU must have governance arrangements designed to ensure that its risk-management and internal audit functions have sufficient authority, resources, independence, and access to the board of directors to achieve risk-management objectives. In addition, the reporting lines for risk management must be clear and separate from those for other operations of the designated FMU and there must be an additional direct reporting line to a non-executive director on the board via a chief risk officer (or equivalent). Further, the risk-management and internal audit functions must each be overseen by a committee, although not necessarily the same committee, of the board of directors. The committee responsible for advising the board with respect to the designated FMU s risk management or for overseeing the audit function must be chaired by a sufficiently knowledgeable individual who is independent of the designated FMU s senior management and be composed of a majority of members who are non-executive members. Finally, proposed 234.3(a)(2)(iv)(J) requires that the designated FMU s governance arrangements be designed to ensure that major decisions of the board of directors are clearly disclosed to relevant stakeholders, including the designated FMU s owners, participants, and 22

23 participants customers, and, where there is a broad market impact, the public. Major decisions include those that would affect the nature or overall level of risk that the designated FMU presents to the relevant stakeholders. Information should be disclosed to the extent that it would not risk prejudicing the security and integrity of the FMU or its participants or divulge commercially sensitive information, such as trade secrets or other intellectual property. With respect to proposed 234.3(a)(2), the Board requests comment on the following specific questions: Q.2.1 Should the Board specify in the rule text other relevant public interest considerations for a specific type of or even for a particular designated FMU? Q.2.2 Should the Board set a specific minimum percentage of individuals on the board of directors that may not be executives, officers, or employees of the designated FMU or an affiliate of the designated FMU? Alternatively, should the standard set any requirements for the participation of outside directors (that is, directors who are not participants in or management of the designated FMU)? Q.2.3 Should the Board require specifically that the chairman of the board of directors be (a) an individual who is not an executive, officer, or employee of the designated FMU or an affiliate of the designated FMU or (b) a different individual than the designated FMU s chief executive officer? Q.2.4 Should there be a requirement for the regular reviews of the performance of the board of directors and its individual board members to include periodic independent assessments? Q.2.5 Should the designated FMU s board of directors be required to have a committee of the board of directors that only has audit responsibilities to which the audit 23

24 function reports and a risk committee of the board of directors that only has riskmanagement responsibilities to which the risk-management function reports? Alternatively, should the designated FMU s audit and risk-management functions be required to report directly to the entire board of directors? Q.2.6 What additional guidance should the Board provide to a designated FMU s board of directors in order to identify a major decision that must be disclosed to relevant stakeholders under the rule? 3. Framework for the Comprehensive Management of Risks Proposed 234.3(a)(3) requires the designated FMU to have a sound risk-management framework for comprehensively managing legal, credit, liquidity, operational, general business, custody, investment, and other risks that arise in or are borne by the designated FMU. A comprehensive risk-management framework is a set of objectives, policies, procedures, and systems that supports the designated FMU in identifying risks, determining a risk-tolerance level, and managing risks. The framework provides an overall mechanism for the designated FMU to address the manner in which the risks, addressed individually by the other proposed standards, relate to and interact with each other. For example, attempts to reduce or limit one type of risk could lead to the concentration or creation of different risks, and, although some risks do not appear to be significant in isolation, they can become material when combined with others. Therefore, robust risk management involves taking an integrated and comprehensive approach to risk in order to understand and manage effectively this interplay among individual risks. Proposed 234.3(a)(3)(i) requires a designated FMU to have risk-management policies, procedures, and systems that enable it to identify, measure, monitor, and manage risk. These policies, procedures, and systems must address the full range of risks and, in particular, 24

25 interactions among these risks that can arise in or are borne by the designated FMU, including those posed by other entities as a result of interdependencies. Proposed 234.3(a)(3)(ii) requires a designated FMU to have risk-management policies, procedures, and systems that enable the designated FMU to identify, measure, monitor, and manage the material risks that it poses to other entities as the result of interdependencies. Such entities include other FMUs, settlement banks, liquidity providers, and services providers. Policies, procedures, and systems must also be designed for a dynamic environment, which includes taking into account the possibility of various economic and financial shocks that may affect the risks presented to or arising in the designated FMU. The entire risk-management framework, including the assumptions used and the component frameworks established for individual risks, must be reviewed and updated periodically to reflect changes in market conditions or the designated FMU s operations. Even with comprehensive risk management, however, a designated FMU may face extreme scenarios that require extraordinary actions by the FMU so that it can continue to provide its critical operations and services as a going concern. The designated FMU s management of these extreme events requires comprehensive, thoughtful planning to avoid disrupting the markets it serves. Therefore, proposed 234.3(a)(3)(iii) requires a designated FMU to develop and maintain recovery or orderly wind-down plans that identify the designated FMU s critical operations and services related to payment, clearing, or settlement; scenarios that may potentially prevent it from being able to provide its critical operations and services as a going concern, including scenarios involving uncovered credit losses (as described in proposed 234.3(a)(4)(vi)(A)), uncovered liquidity shortfalls (as described in proposed 234.3(a)(7)(viii)), and general business losses (as described in proposed 234.3(a)(15)); and criteria that could trigger the implementation of the recovery or orderly wind-down plans. 25